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Markets: Fire Sale!
New York: March 31, 2008
By John R. Stephenson

"Some say the world will end in fire, some say in ice."

--Robert Frost

"If you bail out every investment bank that gets in trouble, that's not capitalism, that's socialism for the rich"

--Jim Rogers

The world may not be coming to an end, but for those that work on Wall Street, it certainly feels like it. For many, the demise of Bear Stearns, the fifth largest U.S. investment bank, was welcome news. The fire sale of Bear Stearns and Cos. Inc. by the Fed to J.P. Morgan was seen by some to be the necessary retribution for the mortgage-related fiasco that has weakened the U.S. dollar, created a severe economic downturn and hobbled the American stock markets.

For some, the disengaged, arrogant attitude of the former CEO and executive chairman of Bear Stearns who sat around playing bridge and smoking cigars while their internal hedge funds were blowing up last summer, was ample proof that the Bear had to be sacrificed. But while Bear Stearns may well have had the most aggressive, hard-charging and winner-take-all culture on the street, it certainly wasn't the only firm to have an asymmetric view of risk and reward.

The sad reality of this debacle is that the Wall Street "geniuses" that created a plethora of collateralized debt products, such as the subprime mortgages that brought Bear Stearns down, will likely be able to continue to whistle past the graveyard. That's because they've already been paid millions for the short-term profits they helped deliver to the Wall Street firms that employed them — and the fact that everyone on the street was in on the fix.

While the collapse of Bear Stearns makes a convenient scapegoat for the ills of Wall Street, it by no means signals to investors that the problems of the street are solved. For starters, there's more bad news to come. The balance sheets of Wall Street investment banks are a shambles as these firms are exposed to billions of dollars of toxic debt that at any moment might explode. Making matters worse, the liberal use of leverage at these firms only exasperates the speed of the descent into the abyss, should major problems surface.

The problem, in part, is societal. We all want immediate results. Investors, analysts and the general public are enamored by the quick fix — a magic bullet that solves all of our problems. For years, the elixir that was sold around the world by these firms was the panacea that weak credits could be packaged in such a way to reduce risk and yet pay yield hungry investors superior returns. Unfortunately, things in the real world didn't work out quite so easily as they did back at the lab in the major Wall Street investment banks.

Bankers who concocted this strange brew were all too happy to cash their hefty bonus checks and keep on dancing — at least until the music stopped. Wall Street firms, eager to attract and retain "the best and the brightest," had little choice but to pay up for these superstars, who, for a time, were able to turn water into wine. The alternative was to loose prestige, stock appreciation and ultimately talent, if a firm was unwilling to adopt anything but a very myopic view of the balance between risk and return. For most Wall Street firms, the risk of being wrong in the long-term was overshadowed by the need to be right in the short-term.

The reason for such a short-termism on the part of investment banks was quite simply greed . According to a recent study by Martin Barnes of BCA Research, the American financial-services industry's share of total corporate profits has zoomed from around 10% in the early 1980s to 40% in 2007. At the same time, the financial-services industry's share of stock market value grew from 6% to 19% while still only accounting for 5% of private-sector jobs. Talk about punching above your weight!

For years, the financial-services industry profited by helping others to trade and manage financial claims on future cash flows, even though the real economy beneath it was beginning to falter. The industry has defied gravity by creatively using debt, securitization and proprietary trading to help boost profitability.

But with the collapse of Bear Stearns, the music has finally stopped for Wall Street. Valuations of the major investment banks still look stretched, particularly when you consider that no one can be certain what risks their balance sheets contain. The next shoe that is likely to drop for the industry is a meltdown in the commercial mortgage backed securities market.

The U.S. economy is grinding slower all the time, residential foreclosures in some cities (e.g. Miami) are approaching 40% of total real estate transactions, yet commercial properties are still being developed. Most likely, many of these will remain vacant for many years to come, sending the financiers of these projects running for the hills. Unfortunately for the major investment banks, the same "innovations" that were used to liberally lend to residential homebuyers has been extended to commercial properties as well.

With billions, if not trillions of dollars of problems yet to work through the financial system, it is still too early to jump back into the stock market . The U.S. financials, with their hefty profit margins, have led the stock market higher for many years. They have been rewarded for their profitability by healthy multiples, which have nowhere to go now but down. Investors would be well advised to avoid the stocks of U.S. financials, which are still at the epicenter of all that plagues the U.S. economy.

Eventually, it will be safe to buy the stocks of financial-services companies, but that will be after multiples compress, stock prices crater and more asset write-downs occur. For our money, that isn't any time soon.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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